S.A Income Tax Rules and Foreign Investment

Income Tax Rules are “Acting” Up.

The allure of foreign markets gleams ever brighter in the turbulent market conditions facing the ordinary South African investor. Considering that since December the JSE All Share Index has lost 4.22% and dropped (at its worst) 10.19%, and that the Rand has lost 10.93%, investors may look to diversify their investments internationally and invest in a more stable currency as an inflation hedge.

How could the ordinary investor access such an investment? There are at least 3 possibilities:

(1) Where, during any year of assessment, a person that is a natural person or a trust that is not carrying on a trade disposes of an asset for proceeds in a foreign currency after having incurred expenditure in respect of that asset in the same currency, that person must determine the capital gain or capital loss on the disposal in that currency and that capital gain or capital loss must be translated to the local currency by applying the average exchange rate for the year of assessment in which that asset was disposed of or by applying the spot rate on the date of disposal of that asset.”

Therefore, investors who acquire offshore investments in hard currency will not be subject to any taxation on the increase in capital value in Rand terms due to currency depreciation. For investors who gain foreign exposure through local investments, this is not the case.

Now, the implication of this definition will be shown through two simple examples:

Example 1:

The investor invests in a locally listed ETF tracking the S&P 500. Since October 2015, the S&P 500 has lost 2.28% and so, should an investor wish to redeem their investment today, they assume they would not be subject to Capital Gains Tax. However, the Rand has depreciated against the Dollar by 15.12% since October 2015, meaning that in terms of the Act, the investor has had a capital gain of 12.84% and is subject to taxation (which is really a loss on the investment in U.S Dollar terms).

Example 2:

The investor utilises their Foreign Investment Allowance or Tax Allowance and purchases an offshore listed S&P 500 ETF on 1 October 2015. Should the investor in this instance sell their investment today, they will not have realised a capital gain for tax purposes. They repatriate their money and pick up a tax free return of 12.84% on the conversion – unlike the investor in Example 1 who would be liable for Capital Gains Tax (up to 14% for individuals and 27% for trusts).

Of course, the shrewd reader may note that the Rand doesn’t always lose 15% against the Dollar in a manner of months and that it may even strengthen against the Dollar, reducing the tax bill (if indeed there is a Capital Gain in foreign currency terms).

However, if one has balanced the risks and rewards of an investment and believes that exposure to a foreign market, e.g. the U.S, will be beneficial then a rational investor should invest in a vehicle which will reduce the expected tax bill. Through the local option, there may be tax levied even if there is a capital loss (due to an exchange rate depreciation), while the same is not true of the direct foreign approach. Even if there is a capital gain in foreign terms, if the Rand depreciates then one would incur more tax.

Further, it is likely that the Rand will continue to depreciate over the long term. Why? Economic theory suggests that a country’s currency will always depreciate against another currency when its inflation rate is greater - South Africa’s inflation rate is far higher than that of developed markets. Therefore, it is safe to assume that a portion of the Rand return would most likely be attributed to the weakening Rand. As such, it makes sense to shelter this return from tax wherever possible.

Although, in our view, the taxation impact of gaining offshore exposure through local vehicles makes it far less efficient than acquiring investment in hard currency, other factors such as costs should always be examined prior to investing.